7 Rules ETF Day Traders Must Know

ETF Database

ETFs are embraced by buy-and-hold investors and active traders alike for their unparalleled ease-of-use and cost efficiency. Short-term opportunities with lucrative risk/reward ratios often appear in the marketplace; however, only the savviest of traders take advantage of them and profit on a consistent basis [see 101 ETF Lessons Every Financial Advisor Should Learn].

Below are seven trading tips that all ETF day traders should have in their personal rule book if they want to increase their chance of success:

1. Write Down Your Trading Rules and Actually Follow Them.

Easier said than done. Most traders fail because they don’t have a trading system in place that keeps them disciplined. Trading rules define how you find trade candidates, execute your strategy, take profits and cut losses. Making trades based on guesses, emotions or random strategies is simply gambling; use a well thought-out and tested trading plan instead. Most traders “know” they should make a trading plan, but actually creating one and following it—the “doing”—is the important part [see How To Swing Trade ETFs].

2. Know When to Stay On the Sidelines.

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Volatility

Knowing when to trade is just as important as knowing when to sit out. Having a well-defined trading plan will tell you when to trade and when not to. Market environments constantly change from ranging to trending, sedate to volatile. Are you equipped with the strategies and discipline to trade profitably in all of these environments? Are you able to determine when the environment is shifting? If not, there will be times you must sit on your hands. Avoid the impulse to trade; only trade when you have an established strategy for doing so.

3. Don’t Try to Pick Tops or Bottoms.

When you start to think you can predict price tops and bottoms, trading gets very expensive. Traders refer to calling a bottom as “catching a falling knife” for a reason; it’s impossible to pick a bottom as the price is falling, instead it will run through you and strip your account. Trying to pick a top in a strong market is no different. When looking to establish a short position after a strong rise, don’t assume you know where the top will be. Trying to be the first trader into a move is a losing battle. Let the market show a reversal is underway—for example, creating a lower price high in the case of downside reversal, or higher low in the case of upside reversal—before establishing a position. You don’t have to be the first trader in, or the last one out, to make a profit [see also Free Report: How To Pick The Right ETF Every Time].

4. Is Your Market Open?

Think fewer participants makes for easy money? Think again. If you are trading commodity/currency ETFs, make sure the underlying market is open, otherwise you may not be getting a fair price according to Horizons Exchange Traded Funds, a major ETF provider. ETFs are linked to the underlying asset by a calculation called NAV, or Net Asset Value; but when the underlying market is closed, the ETF can deviate significantly from this “fair value” due to limited liquidity and wide bid-ask spreads. It is important to note that even during normal market hours the market price of an ETF may fluctuate around its NAV value.

5. Have An Exit Plan.

Define the exact levels at which you will start to take profits or cut your losses. Your exit plan should be covered in your trading rules, but it deserves reiterating. Without an exit strategy we become emotional, letting losses mount or profits slide away. Since it is impossible to predict exact tops and bottoms (see rule #3), simply choose in advance how you will exit losing and winning trades. Trade your plan; take profits or cut losses at pre-established levels or with a personally tested strategy such as trailing stops, Elliott wave theory, Fibonacci levels or other indicators [see ETF Call And Put Options Explained].

6. Tame Your Emotions.

Emotions are inevitable; we all have them. Don’t try to avoid emotion, but rather learn what emotions affect your trading and adapt a plan that accounts for your personal tendencies. Panicking, fear and greed are common emotions, as well as boredom during quiet markets. Whatever your tendency, admit to it and then plan for it. For example, if you get bored and want to start making undisciplined trades, have a demo account open where you can channel your destructive trades, or play solitaire during quiet times. If you have trouble with getting greedy or fearful and not sticking to your plan, use software that allows you to set automatic entry and exit orders (make sure you’re trading high volume ETFs). Don’t ignore your emotions (that’s impossible) and be aware that they will still arise at inopportune times. Instead, plan ahead for your emotions.

7. Review Your Action.

Take time to review your closed trades, both winning and losing ones. Don’t judge yourself on whether you were profitable or lost your shirt; judge yourself based on whether you followed your plan. If you didn’t follow your plan, your results are random and mean nothing over the long run. If you did follow your plan, then judge the plan on whether it works or doesn’t based on profitability and other performance metrics. Adjust your plan accordingly [see also 25 Things Every Financial Advisor Should Know About ETFs].

The Bottom Line

Markets are in a constant state of flux between trending, ranging, choppy, volatile and sedate. Take time to write down how you will trade (enter, exit and manage trades) in each of the conditions you choose to trade. Follow your plan and realize there will be periods when you should avoid trading. Don’t pick tops and bottoms, and make sure your ETF has adequate liquidity during market hours to satisfy your trading style. Know the emotions that affect your trading, and plan for them. Finally, be honest with yourself and constantly evaluate your plan and yourself. If either are not working, stop trading until you come up with a way to overcome the obstacle.

[For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven-day trial to ETFdb Pro]

Disclosure: No positions at time of writing.

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